The SEC just brought a very firm dose of clarification to the cryptocurrency markets.
US Securities and Exchange Commission (SEC) director of corporate finance William Hinman has just clarifiedthat the SEC will not be categorising Ethereum or bitcoin as a security, and that tokens can change function and category over time.
This outcome was widely expected, but still proved enough to give Ethereum prices and trading volume a clear jolt.
Hinman also further clarified the SEC’s line of thinking, saying the organisation was more interested in enforcing the spirit of the law, in line with the letter of the law.
“We should frame the question differently and focus not on the digital asset itself, but on the circumstances surrounding the digital asset and the manner in which it is sold,” he said.
This basically suggests that all ICOs will continue to be classified as securities, as he previously indicated, while new tokens can still be freely distributed through faucets or airdrops without necessarily falling afoul of securities laws.
He also outlined the circumstances where a token can and cannot change its stripes, and morph from a security to a utility token over time.
“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security? In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely ‘no’.”
Hinman also clarified that the tokens of a genuinely decentralised network, and those which are genuinely useful and serve an actual network function, might escape being automatically classified as a security.
“What about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified ‘yes’,” he said.
Ethereum qualifies on both counts because there’s no actual central enterprise being invested in and because the token serves a network function as gas. It probably qualified as a security during its initial sale, but what’s done is done and now it’s home free.
Meanwhile, bitcoin qualifies because there’s no central enterprise being invested in and because it was first distributed through mining rather than a sale. And because it’s reasonable to assume that back in 2009 no one expected actual profits from that gimmicky bitcoin thing.
Elsewhere it might put coins like NEO and its paired GAS token in an interesting position, where one (NEO, or the coin formerly known as Antshares) might qualify as a security but the GAS utility token might not.
EOS might fall on the wrong side of the line, with an exorbitant token sale carried out by a single central and identifiable company, a network that depends on a centralised and identifiable centrefold of block producersand no functional application for the token yet. EOS parent company Block.one was well aware of this during the token sale and explicitly warned buyers that the token did not necessarily serve a purpose or have any value, but that might not satisfy the SEC.
The hard line
The coins that explicitly give holders a financial interest in the enterprise are a minority, but there might still be some grey areas around a user’s expectation of profits from buying or holding a coin. The value of most tokens is dependent on the functionality and value of the network they serve, so there might still be an argument that almost all tokens can represent a kind of financial interest in the network as a whole.
According to Hinman, this might come down to a buyer’s expectations when purchasing a token, and most new token sales would probably fall on the wrong side of securities laws even if the coin does serve a genuine network function.
“Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers,” he said.
“Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network… Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”
Simply slapping a “this is not an investment” sticker on an ICO does not exempt a token from securities laws, Hinman noted.
“For a while, some believed such labeling might, by itself, remove the transaction from the securities laws. I think people now realize labeling an investment opportunity as a coin or token does not achieve that result… simply labeling a digital asset a ‘utility token’ does not turn the asset into something that is not a security.”
Whether a coin is a security depends on the buyers’ expectations, which could naturally go either way, and the resale of securities tokens on a secondary market (the exchanges) can complicate things. Broadly, Hinman suggests that token creators can clear themselves by not just going for a cash grab, not being scammers and genuinely trying to create and distribute an actual functioning and useful product.
That probably rules out most coins.
Ethereum and bitcoin are in the clear, but many others should probably start getting very nervous right about now. According to Hinman’s broad strokes, and definitely not to be used for real legal analysis speech, a coin might be in the SEC’s crosshairs if:
- It was initially distributed and sold in an ICO, or otherwise in a way that qualifies it as a security.
- It does not yet have any genuine utility.
- It has not achieved sufficient decentralisation, and it’s possible to identify a single entity behind the token.